When the Labour Party resumed minority government in March 1974 after a close victory over the Tories in the February election, which had delivered a hung parliament, the British economy was in recession and inflation was running at 12.9 per cent. To resolve the political impasse, he called a further election on October 10, 1974 and gained a majority. The contraction in real GDP began in the third-quarter 1973 under the Tories as the Dash for Growth ended badly and Britain recorded three consecutive quarters of negative growth. Thus, British Labour was on the back foot from day one as a result of inheriting an economy that was in decline as a result of declining investment in best-practice technology as British capital sought lucrative speculative investments abroad. Productivity was falling and the scope for rising standards of living were becoming limited, thus intensifying the struggle over the distribution of income. Many coalmines, a major source of employment and growth, were also reaching the end of their economic life. However, key figures in the Labour government (such as the Chancellor Denis Healey) had fallen into the sway of the emerging Monetarist thinking, which had the consequence of elevating the fraught Monetarist causality to centre stage at the neglect of policies that might have actually addressed the underlying issues. The IMF entered the fray and made matters worse, as usual. Today, we trace the events leading up to this turning point.
The Tory ‘Dash for Growth’, which involved a significant fiscal stimulus to kickstart the economy in 1972. Household consumption was strong as income growth increased.
The strategy was successful inasmuch as unemployment had fallen to 2.2 per cent by December 1973.
However, it was clear that capacity limits were being reached, partly because of the strength of demand, and, partly because of the failure of British capital to maintain robust investment rates to keep the capital stock growing in line with the increased demand.
Further, the strong consumption demand also spilled over into strong import demand.
Taken together, pressures on prices rose, which when combined with the resentment that followed the introduction of the anti-union Industrial Relations Act 1971, led to significant wage demands, as unions tried to protect their real wages and conditions.
Over the course of 1973, Britain’s terms of trade also deteriorated sharply due to the depreciation of the pound (by some 13 per cent between July 1972 and December 1973) and an escalation in world commodity prices.
However, “special measures were employed to limit the depreciation of sterling” (BIS, 1974: 50). The Bank of England tried to restrict the extent to which the pound would fall in the face of a widening current account deficit. In adopting that strategy, the Bank exposed the currency to increased uncertainty and increasing speculative activity, which would ultimately lead to the 1976 currency crisis.
[Reference: Bank of International Settlements (BIS) (1974) Forty-Fourth Annual Report, Basle.]
After a surge in early 1973 as part of the ‘Dash for Growth’, investment expenditure in Britain starting to contract sharply. It fell by 6.5 per cent in real terms in the final year of the Tory rule and it continued to fall through 1974 in the wake of the OPEC oil price hikes. By the December-quarter 1975, investment expenditure had fallen by 18.7 per cent in real terms.
Even with a declining real GDP, the investment to GDP ratio fell from a high of 25.2 per cent in June 1972 to 20.6 per cent by June 1975. By any stretch, this was a massive withdrawal in investment expenditure, which further worsened the slow growth in productive capacity and undermined productivity growth.
The Bank of England also started hiking interest rates in mid-1973 to encourage capital inflow after the pound had fallen in value earlier in 1973. Other monetary policy measures combined to tighten access to credit. By September 1973, the mortgage rate was at 11 per cent, up sharply from 8.5 per cent earlier in the year.
By the last quarter of 1973, inflation had risen above 10 per cent as resource shortages reached critical levels and the Bank of England pushed up interest rates to 13 per cent and placed further restrictions on the credit creating capacities of the commercial banks.
Industrial turmoil (miners’ strike, three-day week) also reached a crescendo late in 1973 as the British economy reached a point where productive capacity was exhausted and inflation was being pushed up by the surge in import prices and the resistance of firms and unions to accept the associated real income losses.
The last Tory government also announced their intention to cut public spending over 1974-75 – 20 per cent in capital infrastructure cuts and 10 per cent in recurrent outlays. Tax increases were also foreshadowed.
The three-day working week imposed after the OPEC oil crisis and the Miners’ strike later in 1973 also significantly reduced real GDP growth.
The newly elected Labour government determined in its first fiscal statement in March 1974 to maintain the austerity although it did not accept the Tory’s prices and incomes policy, that was drafted prior to the oil shocks and as hindsight tells us, grossly underestimated the impact of the imported oil price rise on the local inflation rate.
However, the reality was that despite a fiscal contraction being necessary given the overheating economy, the Labour government oversaw a substantial increase in the fiscal deficit to avoid recession as the world economy was slowing after the OPEC price hikes.
The OPEC oil crisis had a major impact on the British Balance of Payments, which, as a result of the lagged payment structure typically in place for oil imports, was first evident in the early period of Wilson’s regime.
As the Bank of International Settlement’s noted (BIS, 1974: 6):
… oil imports are customarily paid for some three months after the oil is actually “lifted” in the producer countries, the first payments on the basis of the prices posted at the end of 1973 did not begin to be felt until April 1974.
In the context of an inertial sense that exchange rate fluctuations should be minimised, the widening current account deficits for oil importing nations such as Britain posed the issue of how to finance them. Clearly, existing reserves would soon be depleted if these funds were drawn upon.
The emerging Euro-currency (or Euro-dollar) market, which had developed to get around the rigid restrictions on capital flows under the Bretton Woods system of fixed exchange rates, provided many nations with the funds necessary to bolster capital inflow to offset the current account deficits.
The market also became a conduit for recycling balance of payments surpluses in oil-producing nations to oil importing nations.
The BIS reported (1974: 7) that:
Total syndicated Euro-credits raised during the first quarter of 1974 amounted to $ 13.8 milliard, of which France, Italy and the United Kingdom accounted for nearly two-thirds — virtually all of it under official auspices.
The Labour government did come to an agreement with the miners to offer a pay rise of around 30 per cent, which was greater than the offer possible under Phase III of the Tory’s incomes policy. The Government wanted to avoid the on-going disputation and begin dialogue which would lead to the acceptance of a ‘social contract’ with the unions to maintain voluntary wage restraint.
The first fiscal statement of the Wilson Labour government thus provided inducements to workers and pensioners but imposed tax hikes for high income earners and introduced ighter tax rules to restrict tax evasion and avoidance.
To further appease the trade unions, the Wilson government repealed the pernicious 1971 Industrial Relations Act and in July 1974, replaced it with the Trade Union and Labour Relations Act 1974. In addition, the Government brought in an accompanying act, the Employment Protection Act 1975. which formed the basis of the Social Contract with the workers.
These legislative initiatives were favourable to workers and sought to reduce the industrial conflict that the Heath Government had provoked. They were also a key part of the Wilson government’s attack on inflation.
The British government agreement with the unions involved an exchange of broader and more generous social welfare benefits for wage restraint. In other words, an increase in the social wage to compensate for a lower rise in the negotiated wage with employers.
While industrial disputation was not entirely absent, the unions, by and large, were accommodating to the Government’s call for wage restraint and negotiated outcomes.
However, within that ‘accommodation’, wage rises were still beyond the capacity of the economy to absorb, given the intent of capital to maintain their share of the pie.
In November 1973, the Tory government had agreed to various wage increases as part of its prices and incomes policy and the third stage of these rises was triggered by certain threshold price level rises. The oil price hikes triggered the wage rises well before they were expected and as such unit costs rose quickly by mid-1974, squeezing profit margins further.
There was also a major public sector wage rise granted as part of the social contract.
The July 1974 fiscal statement foreshadowed an expansionary policy framework to offset the slowing world economy. As the BIS say (1975: 43):
There was a large increase in real personal disposable income, augmented by the budget measures in July. However, personal saving mounted sharply, so that real personal consumption did not rise above its year-earlier level until the fourth quarter of 1974. Current government expenditure increased — a direct reflection of higher public-sector wages — while gross fixed investment showed a moderate fall.
[Reference: Bank of International Settlements (BIS) (1975) Forty-Fifth Annual Report, Basle.]
Exports also declined in late 1974. Earlier, the declining British pound had stimulated exports. Between 1972 and 1975, once the pound was floated after the breakdown of the Smithsonian Agreement, the pound depreciated by 12.7 per cent.
The BIS (1974: 11) note that:
Increased competitiveness resulting from the floating of sterling contributed to a sharp advance in the exports of the United Kingdom, but this seemed to peter out in the autumn as capacity limitations came into play.
The problem of export capacity was a direct result of the failure of British capital to sustain investment rates in local productive capacity.
The other problem was that, given Britain’s high import dependency, the exchange rate depreciation, added to the inflationary pressures even before the OPEC oil shocks arrived.
As nations tried to adjust to the breakdown of the Bretton Woods system and the Smithsonian Agreement, which was an attempt to revive the fixed exchange rates, various unilateral currency realignments were made, which then pressured their trading partners.
Britain’s real GDP declined in the fourth-quarter 1974 and unemployment started to rise sharply marking the start of the stagflationary period.
The household sector’s saving ratio had risen substantially given the mounting uncertainty and the current account deficit persisted. Bank lending also contracted sharply in 1974 and the Eurocurrency market for loans seized up.
Mackinnon notes (1977: 30) that:
Stories appeared in the financial press in 1974 that some Eurobanks refused to accept large OPEC deposits,some creditworthy borrowers were being turned away, and there was insufficient equity capital in the Eurobanking system to service the oil transfers.The situation was exacerbated at the time by the failure of two large banks, Herstatt and Franklin National, because of unsuccessful speculation in foreign exchange.
[Reference: Mackinnon, R.I. (1977) ‘The Eurocurrency Market’, Essays in International Finance, 125, Princeton University.]
This was a time when “monetary authorities were determined to slow inflation” and short-term interest rates rose “extraordinarily high relative to longer-term bond rates” (Mackinnon, 1977: 31). This distorted the so-called maturity transformation function of the international banking sector: “the OPEC investors tried to invest mainly at very short term … governments and enterprises in the oil-importing countries wanted to borrow at much longer term, because several years might elapse before their exports expanded sufficiently to cover the amortization costs of current borrowings”(p.31).
The squeeze on profits also undermined capital formation.
The British government opted in its November 1974 fiscal statement to provide major tax and other concessions to business firms in Britain, which combined with the wage rises agreed throughout the public sector saw the fiscal deficit increase substantially from £4,225 million in 1973 to £6,365 million (or 10 per cent of GDP) in 1974.
It is clear that the social contract with the unions had led to a moderation in the inflation rate. The BIS (1976: 29) concluded that:
… a major factor in the slowing-down of price inflation was the acceptance by the trade unions of a programme of voluntary restraint on wage increases.
However, it remains a fact that Britain did not adopt a hard anti-inflationary policy stance as did Germany, Japan and the United States at the time. As part of the social contract, Britain clearly tried to minimise the damage to employment of their anti-inflationary strategies.
But we need to be careful here. A major driver of the rise in domestic prices came from import price rises following depreciation and the trade union response was more reactive rather than that of a first-mover.
The deep recession that the world endured between 1974 and 1975 gave way to recovery in late 1975. Britain recorded its first quarter of stronger growth in December 1975 (1.2 per cent) after several quarters of negative or weak growth from the third-quarter 1973.
The BIS (1976: 3) noted that:
After the combination of inflation and recession had dealt a sharp blow to confidence, business and consumer optimism rapidly revived, arid the recovery seems to be developing much along text-book lines. This favourable turn of events owed a great deal to the action of governments, which had successfully applied the necessary measures to prevent the recession from degenerating into depression.
Elevated unemployment levels persisted and inflation peaked at 26.9 per cent in August 1975 before receding.
[Reference: Bank of International Settlements (BIS) (1976) Forty-Sixth Annual Report, Basle.]
The decline in business investment also ended as firms reduced their debt levels and regained some sense of confidence. Importantly, the BIS (1976: 4) observed that:
The huge rise in the public sector’s financing deficit does not yet seem to have “crowded out” anybody. In fact, since there was a sharp net fall in the business sector’s demand for credit, it was easily financed by the sizable increase in household savings.
For Britain, however, the recovery brought an increasing current account deficit as imports started to rise on the back of rising national income.
This was accompanied by increasing turmoil in the European currency markets. In early 1975, the Italian lira was significantly devalued to avoid speculative pressures and the British pound also depreciated substantially.
After abandoning the ‘snake’ in January 1974, the French franc re-entered the exchange rate arrangement July 10, 1975 at the original parity agreed in the Basel Accord. The Swiss government negotiated an entry in September 1975 but by November, it decided not to exercise that option given ongoing instability.
Then on March 15, 1976, the French franc again exited the ‘snake’ never to return, and in October 1976, the German mark was revalued by a further 2 per cent as it became difficult for the Bundesbank to keep the currency within the agreed limits.
The withdrawal of the French franc from the ‘snake’ in March 1976 exemplified the problem facing the non-German membership of the agreement: either they had to continually devalue their currencies or create high domestic unemployment to reduce imports. Neither option was politically tenable. Even after the revaluation of the mark in October 1976, the remaining currencies were under pressure.
While Britain was not part of the ‘snake’ agreement, the currency turbulence, given its expanding external deficit was a major problem.
It was still experiencing high inflation and was faced with further mark-downs in its currency.
Britain was also enduring a low productivity malaise where demands on real income growth by the claimants – labour and capital – had to be moderated, if the inflation spiral was to be tamed.
Despite the persistently high inflation, real monetary growth in Britain was sharply negative between 1973 and the end of 1975 which cast doubts on the Monetarist causality.
Having been infested with the Monetarist logic, the Labour Chancellor, Denis Healey made much of the link between money supply and the inflation experience as he teased his Tory opponents in the Parliament.
In the House of Commons (March 27, 1975), Healey said (HC Deb 27 March 1975 vol 889 cc667-73):
I think that there is now general agreement on both sides of the House that the major cause of the inflation now racking Britain is the excessive increase in the money supply which took place in the last year of the previous Conservative Government.
He later told the Commons (February 5, 1976) in answer to a Dorothy Dixer question from a Labour colleague about the respective performances of the previous Tory and current Labour government in ‘controlling’ the money supply, that (HC Deb 05 February 1976 vol 904 cc1396-8):
For those who are interested in controlling the money supply, the fact is that my achievement on M3 was four times superior to that of the Conservative Government, which allowed M3 to increase in their last year of office, 1972 to 1973, Q4 to Q4, by 29 per cent. as against a 13 per cent. increase in money GDP. The figures for Q3 1975 on Q3 1974, showed an 11 per cent. increase in M3 as against a 21 per cent. increase in money GDP over the same period.
He was then asked why the performance was superior, to which he replied:
Primarily to the far superior fiscal probity of the present Administration.
A British conservative MP then responded by suggesting that the slowdown in the money supply growth was “that investment is now declining and the rate of increase of consumption is falling dramatically”.
The BIS (1976: 35) considered that the decline in the growth of the money supply in Britain (and other nations such as Japan and the US):
… may also reflect the sharpness of the decline in the private sector’s demand for bank credit, which made it a great deal easier to achieve moderation in the growth of the money supply.
The BIS (1976: 37) also said that “The more fundamental problem, however, concerns the actual degree of control that a central bank is able, given the particular socio-political context in which it operates, to exercise over the quantity of money”.
The point is that the monetary authorities were really unable to control the growth in the money supply, which was largely endogenously generated by the demand for credit by the non-government sector. Once real GDP declined and business investment followed suit, the demand for credit collapsed between 1974 and 1975 as did the growth in the money supply.
Aled Davies (2012: 13) also points out that while Healey had held out that the social contract was the Labour government’s principle inflation-fighting policy tool and “that people tend to exaggerate the importance of the money supply” (HC Deb 05 February 1976 vol 904 cc1396-8), Healey still strengthened the Monetarist cause:
Yet it is clear that by proclaiming successful control of the money supply as one of his Government’s achievements, the Chancellor served to cement a widespread belief within financial markets that the Government did attach importance to the monetary aggregates and was operating a strict monetary policy. The result was to establish a situation in which the success or failure of the Government’s counter-inflationary policies could be easily measured according to the behaviour of the monetary indicators.
It is also worth noting that while the fiscal deficit in Britain was rising quite substantially in 1975 and the British government was borrowing heavily from the banking system, the claims by the Monetarists that there would be ‘crowding out’ of private investment through higher interest rates were not validated.
The BIS (1976: 47) concluded that:
The concern, at times widespread, that heavy government borrowing would result in pressures on interest rates or in a monetary explosion seems in the event to have been excessive or at least premature.
The major factor driving interest rates in Britain at the time was the desire of the Bank of England to bolster the pound, which was coming under increasing pressure. The Bank tried to maintain a spread between domestic interest rates and the US dollar interest rates to encourage capital inflow to offset the large current account deficit on trade.
The external deficit decreased in 1975 as a result of the recession with exports falling by less than imports. But with recovery emerging late in the year, the outlook for 1976 was for an expanding trade deficit.
The defence of the sterling by the Bank of England in 1975 had led to a significant decline in its stock of foreign currency assets:
In the official sector currency reserves declined by $1.5 milliard during the year. The total of official intervention in support of sterling was, however, much greater. Thus, in the first quarter the government drew the remaining $1 milliard of its $2.5 milliard
1974 Euro-currency loan, while in addition the reserves benefited to the extent of $0.9 milliard from other public-sector foreign currency borrowing (BIS, 1976: 71.
Britain was approaching a crisis. Its exchange rate was constantly under pressure to depreciate, and the evidence suggests that domestic wage rates were highly responsive (through real wage resistance) to the price rises induced by rising import prices.
The crisis began in April 1976 when speculative attacks on the pound intensified.
In the final instalment of this part of the story – Britain and the IMF – next week, we will consider how the British government handled the crisis.
What they did and what they should have done. It will be more analytical and less historical and descriptive than today’s blog.
The series so far
This is a further part of a series I am writing as background to my next book on globalisation and the capacities of the nation-state. More instalments will come as the research process unfolds.
The series so far:
The blogs in these series should be considered working notes rather than self-contained topics. Ultimately, they will be edited into the final manuscript of my next book due later in 2016.
FINALLY – Introductory Modern Monetary Theory (MMT) Textbook
The KINDLE edition is now out – Details – or through the relevant Kindle store for your currency (you can search for the relevant link).
We have now published the first version of our MMT textbook – Modern Monetary Theory and Practice: an Introductory Text (March 10, 2016).
The long-awaited book is authored by myself, Randy Wray and Martin Watts.
It is available for purchase at:
1. Amazon.com (60 US dollars)
2. Amazon.co.uk (£42.00)
3. Amazon Europe Portal (€58.85)
4. Create Space Portal (60 US dollars)
By way of explanation, this edition contains 15 Chapters and is designed as an introductory textbook for university-level macroeconomics students.
It is based on the principles of Modern Monetary Theory (MMT) and includes the following detailed chapters:
Chapter 1: Introduction
Chapter 2: How to Think and Do Macroeconomics
Chapter 3: A Brief Overview of the Economic History and the Rise of Capitalism
Chapter 4: The System of National Income and Product Accounts
Chapter 5: Sectoral Accounting and the Flow of Funds
Chapter 6: Introduction to Sovereign Currency: The Government and its Money
Chapter 7: The Real Expenditure Model
Chapter 8: Introduction to Aggregate Supply
Chapter 9: Labour Market Concepts and Measurement
Chapter 10: Money and Banking
Chapter 11: Unemployment and Inflation
Chapter 12: Full Employment Policy
Chapter 13: Introduction to Monetary and Fiscal Policy Operations
Chapter 14: Fiscal Policy in Sovereign nations
Chapter 15: Monetary Policy in Sovereign Nations
It is intended as an introductory course in macroeconomics and the narrative is accessible to students of all backgrounds. All mathematical and advanced material appears in separate Appendices.
Note 1: There is a typographical mistake in the book which although not repeated might throw your understanding. This has been corrected in a revised edition which is now being sold.
In editions sold before April 19, 2016, the following errors occur:
On Page 138, Equation 7.15a is written as
(7.15) Y = E = A + [c(1-t) – m]Y
and solving for Y is then stated to give
(7.16) Y[1 – c(1-t) – m] = A
however this should instead read Y[1 – c(1-t) + m] = A.
Thanks to Brian S. for picking this up.
Note 2: We are soon to finalise a sister edition, which will cover both the introductory and intermediate years of university-level macroeconomics (first and second years of study).
The sister edition will contain an additional 10 Chapters and include a lot more advanced material as well as the same material presented in this Introductory text.
We expect the expanded version to be available around June or July 2016.
So when considering whether you want to purchase this book you might want to consider how much knowledge you desire. The current book, released today, covers a very detailed introductory macroeconomics course based on MMT.
It will provide a very thorough grounding for anyone who desires a comprehensive introduction to the field of study.
The next expanded edition will introduce advanced topics and more detailed analysis of the topics already presented in the introductory book.
That is enough for today!
(c) Copyright 2016 William Mitchell. All Rights Reserved.